Why we should ban reverse converts

By Felix Salmon

June 18, 2009

I had no idea what a can of libertarian worms I was opening when I suggested that the sale of reverse convertible bonds should be banned. I dealt with one line of objections last night — the silly idea that since reverse convertibles are basically a put-writing strategy, and since Warren Buffett writes puts, then reverse convertibles must be kosher.

But now a more invidious objection has cropped up, as hilariously encapsulated by Daniel Indiviglio:

Its usefulness must be clear to someone — otherwise there would be no market demand for the product, and one never would have been sold.

I must admit I laughed out loud on reading that. Reverse convertibles are sold by banks as a way of generating cheap capital and hefty fee income. No one in the history of the world has ever approached their stockbroker with a bright idea that what they really want to do is lend a bank a few thousand dollars at a high interest rate, but would be happy to receive depreciated Apple stock instead of their money back if AAPL does badly over the next few months.

Indiviglio and his fellow-travellers like Vincent Fernando have been defending reverse converts on the grounds that (a) you can view them as sophisticated options-writing strategies and that (b) sometimes sophisticated investors actually want to enter into such strategies.

But people, these things are called reverse convertible bonds. The options-writing part of the deal — which is the beating heart of these instruments — is generally downplayed to the point of invisibility, while all of the emphasis is on the juicy “coupon” being paid by the bank. (Which is really the bank buying a cheap option from the investor.)

Here’s Fernando:

I don’t think we should be banning products just because we ourselves believe that others are fools for buying them. Rather, I think it’s healthier if we encourage a culture of skepticism towards any investment opportunity rather than banning cherry-picked products completely and implying that the approved products are “safe”. We trust almost anyone to have the brains to drive a car at deadly (upon impact) speeds, yet not to do a little homework towards a financial product?

You need to think hard when you invest substantial sums of money and you shouldn’t give much weight to the words of the guy selling you the product. For any product. Too big of a financial decision for the average person? I doubt it. We let people choose their career types, their schools, their houses, etc. We don’t say the average Joe isn’t sophisticated enough to buy a house. And we shouldn’t.

I think we’re seeing right now what happens when the average Joe buys a complex financial instrument (a subprime mortgage) which he doesn’t understand. The whole point of the Consumer Financial Protection Agency is to prevent predatory lenders from talking naive individuals into products which are egregiously unsuited to them. Similarly in this case, stockbrokers should be prevented from persuading naive individuals to start writing underpriced put options while kidding themselves that they’re just buying a high-interest short-dated bond.

Mike at Rortybomb has a great post on all this, with a couple of very sensible principles:

People are Poor with Estimating Tail Risk; They Underestimate it

People should be discouraged, though not prevented, from profiting by taking on excessive tail risk. If they do want it, they should be made very aware of what they are doing.

People are Poor at Understanding Embedded Options

When embedded options are hidden inside financial products, they should be made very clear, and if reasonable, broken out into another product.

In general, we shouldn’t assume that most Americans can, will, and should “do a little homework” before buying something from their friendly stockbroker. This is why it’s so good and so important that stockbrokers are soon going to have a fiduciary duty: they won’t just be able to blithely sell nuclear waste to their clients any more. But more to the point, most Americans aren’t remotely financially literate enough to understand this stuff. They’re not good at math, they barely understand the difference between a stock and a bond, and they certainly should have no business playing in the options market. (Similarly, an enormous number of investors in the USO exchange-traded oil fund should never have bought it because they think they’re just buying a proxy for the spot oil price, and they don’t have a clue what contango is. If you don’t understand the dynamics of contango, you have no business buying USO.)

People who live and breathe the financial markets are more than welcome to do all manner of sophisticated things in those markets if they’re so inclined. As Mike says, if you want to short a straddle on AT&T stock, go right ahead. But retail-facing financial instruments should never embed such bets, because retail investors, as a rule, lack the sophistication necessary to be making such bets in the first place.

Fernando looks at those investors and says it’s “their responsibility to be skeptical buyers”. No. It’s the stockbroker’s responsibility to act in the investor’s best interest, and it’s the government’s responsibility to prevent the sale of products which can end up being extremely damaging to those who buy them. As Elizabeth Warren famously says, no one has a problem with the government banning the sale of dangerous toasters, and dangerous financial products cause much more damage than dangerous toasters ever do.

The fact is that reverse converts, in particular, are the kind of product which can cause a great deal of harm; what’s more, they exist entirely so that banks can use their stockbroking arms to rip off their clientele. Banning them would do much less harm than selling them. So let’s ban them, and their ilk.